When the Growth Model Changes, Abandon the Correlations – Business Insider

This is why I think it is much more appropriate to compare China today with Japan in the late 1980s. Japan in the late 1960s and early 1970s may share many developmental characteristics with China today, but the Japanese economy in that earlier period never achieved, as far as I can see, the kinds of imbalances that it did much later in the 1980s, and so it is not really comparable to an extremely unbalanced China today.

These imbalances are well documented. The important characteristics of Japan in the late 1980s would almost certainly include the following:

Japan in the late 1980s grew at extraordinary rates fueled by a credit-backed investment boom funded at artificially low interest rates.

Although for many decades much of the investment may have been viable and necessary, by the 1980s investment was increasingly misallocated into expanding unnecessary manufacturing capacity, as well as fueling surges in real estate development and excess spending on infrastructure.

Artificially low rates, set nominally by the central bank but in reality by the Ministry of Finance, and coming mainly at the expense of household savers also fueled a bubble in local assets.

An artificially low currency fueled very rapid growth in the tradable goods sector while also constraining household income growth.

Because the growth model constrained growth in household income and household consumption, it forced up the domestic savings rate to extraordinary levels.

The combination of low consumption and excessive manufacturing capacity required a high trade surplus in order to balance production with demand.

And finally, and most worryingly, debt levels across the economy began to soar as debt rose much faster than debt servicing capacity.

All of this is true of China today, and this is why it is much more important to understand how Japan rebalanced after 1990 if you want to understand the challenges and risks facing China today. China is not like Japan in the 1950s, 1960s or 1970s in any meaningful way even if its current development level is much closer to Japan during those decades. Because of the serious imbalances China is much more like Japan in the late 1980s, with the major difference being that Japan never took debt, investment, and consumption imbalances to anywhere near the levels that China has taken them.

For this reason what we really have to consider when thinking about China is how these imbalances tend to be reversed. Since they were reversed in Japan in the period following 1990, Japan provides at least one possible model for China’s rebalancing process and, perhaps much more importantly, it demonstrates the kinds of pressures that China will face as it is forced into rebalancing.

This insight, by the way, extends to a lot more than just Chinese economic growth over the next decade. It is applicable whenever a system that has generated unsustainable imbalances is in the process – as it eventually must – of reversing these imbalances. In that case it is a waste of time to extrapolate from the development of variables during the period in which the imbalances were created to the period in which the imbalances are reversed.

With a change in the growth model comes a radical change in the relationship between underlying variables and their impacts on growth. It makes no sense to use the earlier data series, adjusting them according to new conditions, and to project new data series, because when a country is forced into reversing the imbalances, by definition all the correlations between relative inputs and outputs must fall apart, and the more extreme the imbalances that need to be reversed, the more untrustworthy the previous relationships. In that case it is much more useful to posit the various ways in which a reversal of the imbalances must occur.